As I write this the S&P 500 sits at an historic high, which took 15 months to set from its previous high. For those of us who are patient, disciplined, and faithful to the plan, we should be pleased with our steadfastness. We are, perhaps, even stocking up some dry powder for when the market gives us an opportunity to buy at a discount, which it inevitably will.
And of course the punditry continues to issue the same breathless proclamations about the unsustainable levels of the markets, just as they always have and always will.
It makes me think about risk, and how it's misapplied for investing. When you hear the word "risk" as it applies to your investments, what do you think it means? There's a quote by Will Rogers where he said, "I am not so much concerned with the return on my money as I am with the return of my money."
In other words, taking on risk in investing is similar to placing a bet on a roulette table. Sometimes you win, sometimes you lose. To me, that sounds more like gambling or, relative to investing, speculating. And speculating is not investing.
Most people hear the word risk and think about the volatility in the stock market. The investment industry has adopted this definition as well. In fact, the term, "risk-free rate" applies to the return of an investment with virtually zero risk, specifically default risk.
definition: Risk-free rate
The risk-free rate is the theoretical rate of return of an investment with zero risk, typically measured by the yield on the 3-month U.S. Treasury Bills.
Financial advisors use risk tolerance questionnaires to determine their client's appetite for risk in their investments or at what amount of volatility the client demands to be pulled out of the market. Most investment portfolios are designed around the idea that the client's investments should be balanced to take on the maximum amount of risk with which the client feels comfortable, and the returns of the investments are thereby a function of that level of risk.
It seems fair, but I think there's a better way to look at it.
Let's take for example an average, risk-averse investor who has experienced the volatility in the stock market and says, "I can't stand to take any risk in my investments. Therefore, I will take all my money out of the stock market and place it into risk-free Treasury bonds so I'll be nice and safe."
When risk is evaluated in terms of volatility, this strategy of avoiding risk to avoid volatility seems prudent. Stocks are volatile. They go up and down, in seemingly random order and magnitude, and that means they are risky because the value of your investments tomorrow may be lower than their value today. So, to avoid risk, simply avoid risky investments.
But what if, upon further analysis of the investor's financial situation, being 100% invested in risk-less investments is actually a high-risk endeavor? What if this investor's "risk-free" investment strategy nearly guaranteed he or she would run out of money at some point in their future because his or her investments failed to grow at a rate necessary to fund long-term goals?
What if the strategy of reducing investing risk actually increases the chance of running out of money?
If your investment strategy is designed exclusively around the level of volatility with which you are comfortable, you are ignoring a huge piece of the puzzle that is your financial plan. If you aren't considering lifestyle expenses, taxes, life expectancy, inflation, your net worth, and many other bits of information, you're flying in the dark.
Instead, if you incorporate these details into your financial plan, you can determine how much risk you need to take to improve the odds your investments will grow enough to fund your financial plan. Call this your required rate of return, and approaching risk this way is 180º from how you are taught about investment risk.
Definition: Required Rate of Return
The long-term rate of return necessary to grow your investments so your financial goals are adequately funded, according to the completion of the recommendations in your financial plan
Sometimes, the required rate of return is higher than an investor is pursuing, because they're spending too much or not saving enough to fund his or her goals. Other times, an investor can take on less risk and invest with less fluctuation and more predictability because his or her assets are enough to pay for their lifestyle for the rest of their life. Either way, the required rate of return reveals the amount of risk you should be taking, whether or not you're comfortable.
Viewing risk only from the perspective of volatility misses the mark.
Therefore, a more relevant definition of risk, as it applies to financial planning, is the chance that you're going to run out of money before you run out of days on this earth.
What you sacrifice by eliminating risk from your investments is not volatility, but growth. That growth may be critical to funding your financial planning goals and reducing the opportunity for your investments to grow may be the riskiest thing you can do with your finances.
A risk-free investment portfolio can lead to disaster, comfortably and safely. Which do you think would be more uncomfortable, suffering through the volatility of the stock market or spending the last days of your life in poverty?
From now on, when you think of volatility in your investments, don't call that risk. Instead, call it fluctuation.
Risk = Fluctuation
Stocks fluctuate, but a well-balanced, diversified portfolio designed to pursue your required rate of return greatly improves your chances of investing success.